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Unbreakable Bonds

LATE last year a well-known financial analyst, Meredith Whitney, predicted that “50 to 100 sizable defaults” by state and local governments, amounting to hundreds of billions of dollars, were just around the corner. Since then that fear has produced a near-panic, with municipal bond markets down significantly and some even calling for a law to let states declare bankruptcy.

But this fear of an imminent bond crisis reflects a profound misunderstanding of the differences between the short- and long-term challenges facing state and local governments, and what these governments can do to address them. Indeed, such talk hurts those governments in the long run by undermining investor confidence and raising their borrowing costs.

Municipal bond default is actually quite rare: no state has defaulted on a bond since the Depression, and only four cities or counties have defaulted on a guaranteed bond in the last 40 years. A few minor bond defaults do occur each year, usually on debt issued by quasi-governmental entities for projects that didn’t pan out, like sewers for housing developments that never were occupied.

Indeed, last year’s total defaults amounted to just $2.8 billion — a drop in the bucket compared to the nearly $3 trillion in outstanding municipal bonds. The leading rating agencies estimate the default rate on rated municipal bonds of any kind at less than one-third of 1 percent; in contrast, the default rate on corporate bonds reached nearly 14 percent during the recession and hovers around 3 percent in good times.

So why are so many people afraid of a looming wave of bond defaults? The confusion is rooted in a failure to distinguish between cyclical budget problems and the longer-term soundness of state and local borrowing.

State and local budget deficits need to be understood in context. These governments always have trouble balancing their budgets during economic downturns, and this downturn has been worse than most. The 2007-2009 recession and the slow recovery, along with housing foreclosures, caused a big drop in state and local revenues; state revenues remain an estimated 11 percent below what they were before the recession.

Meanwhile, state spending on public services has risen, driven in part by increases in the numbers of unemployed and newly poor residents. The result has been huge and continuing, but understandable, deficits.

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Gary Taxali

Such deficits make for frightening headlines because these days, most governments are legally required to balance their budgets each year, and they have been closing those gaps by cutting programs and raising taxes, neither of which sits well with voters.

But these operating deficits are cyclical: as the economy picks up, demand for social services will decline and tax revenues will increase, just as they have after previous recessions.

To be sure, states also suffer from longer-term “structural deficits” because their revenues are not growing as quickly as their costs of providing services even during good economic times. These structural deficits, which states must address, make it harder for them to meet their responsibilities each year.

However, that doesn’t mean their bonds are in trouble. Bonds are a long-term obligation. They finance projects like bridges, highways and school buildings — not, with very few exceptions, annual operating costs. And by law most state and local governments must pay bond interest before financing any public services.

True, state and local governments do have to make annual interest payments on their bonds, but these payments represent a modest 4 percent to 5 percent on the whole of current spending — no more than in the late 1970s. And, while total state and local bond debt has risen slightly over the last decade as a share of the economy, it is no higher today than it was at times in the 1980s and 1990s.

On the rare occasion when a local government faces the risk of default, the state typically steps in and creates a control board or other mechanism to straighten out its finances and assure that bondholders get paid; New York did so when Nassau County’s finances deteriorated in 2000 and again this year. Pennsylvania gave the same assistance last year to Harrisburg, which had issued bonds for an overly ambitious trash-to-energy project.

Some doomsayers liken today’s municipal bond market to the mortgage bond market before it burst. But that’s a false comparison: state and local governments haven’t changed the frequency or quality of bonds issued, as occurred with subprime mortgage bonds.

Nevertheless, the fear of imminent defaults has led some politicians to call for a federal law allowing states to declare bankruptcy. That’s a solution in search of a problem that doesn’t exist — and a dangerous solution at that, since it likely would undermine investor confidence and thereby increase state borrowing costs for necessary capital improvements.

None of this is to say that the country’s finances, whether at the federal, state or local level, aren’t without serious problems. But it’s one thing to talk reasonably about long-term difficulties, and another to spread fear about a bond-default apocalypse. Doing so might win political points, but it makes finding real solutions much harder.

Iris J. Lav is a senior adviser at the Center on Budget and Policy Priorities.

A version of this op-ed appears in print on March 21, 2011, on page A25 of the New York edition with the headline: Unbreakable Bonds. Today's Paper|Subscribe